Microsoft Sales Up in Third Quarter, but Profits Fell

by Timothy Prickett Morgan

If the growing revenues of Microsoft are any indication, then business is on a modest upswing and the IT industry might be recovering to a level of predictable (but not large) profits. Microsoft announced its fiscal third quarter financial results last week, and both revenues and profits were up smartly. However, net income was impacted negatively as Microsoft shelled out billions of dollars to settle a number of huge lawsuits.

Microsoft booked $9.18 billion in sales for the quarter, up 17 percent compared with the third fiscal quarter of 2003. No established IT player is growing at this rate, certainly not a company as large as Microsoft. This is real growth, driven by a real uptake of Microsoft products. Scott Di Valerio, Microsoft's corporate controller (the guy who counts the beans), said that nearly all of the company's segments exceeded sales expectations and nearly all grew at double-digit rates. If the IT market is not recovering, the Microsoft market sure looks like it is. Microsoft's net cash from operations was $4.97 billion, up 19 percent, but after taking out $748 million to cover stock-based compensation and $2.53 billion related to the settlement with Sun Microsystems, Microsoft's net earnings dropped by 39 percent, to $1.32 billion. Still, Microsoft did grow its cash hoard to $56.4 billion, up a few billion dollars in the quarter. Microsoft's business and legal strategies are clearly working.

In the Server and Tools Division, which is the most interesting for IT shops, sales were up 19 percent, to $2.18 billion, but because the development tools business that is related to Java took about half of the hit for the Sun settlement, this segment booked an operating loss of $635 million, compared with an operating profit of $305 million this time last year. Microsoft said that revenue for Windows 2000 and Windows 2003 server platforms increased by 25 percent and that shipments were up by 31 percent, compared with the fiscal third quarter of 2003. Including sales for Client Access Licenses (CALs) and all server and middleware products, Microsoft's server products saw sales grow by 445 million, or 36 percent, in the quarter, which means that server products and their related CALs accounted for $1.24 billion, or 57 percent, of sales for this division. Windows Server 2003, SQL Server, and Exchange Server were singled out as doing well, which stands to reason, since these are the pillars of the Windows Server System.

John Connors, Microsoft's chief financial officer, said that the company's Small Business Server 2003 variant of Windows 2003 was selling at a factor of 1.7 better than the equivalent SBS variant of Windows 2000 during its first six months. Connors added that Windows 2003 was the most successful Windows server rollout by the company to date, with over twice the revenue and shipments of prior generations during the same time. Connors said that he was expecting that server hardware shipments across all platform types would be up 14 percent in Microsoft's fiscal fourth quarter, which ends in June, and that he expected that Windows server shipments would outpace this rate as X86 servers gain share and other platforms lose share. For fiscal 2005, Microsoft is forecasting that server shipments will grow by 11 to 13 percent, and that it can again outpace the industry. But Connors did not want to set expectations too high.

"We are in the midst of a corporate recovery," Connors said in a conference call with Wall Street analysts last week. "We expect the improvement in corporate sales to continue throughout the year." But even with server shipments up, he warned that, because Microsoft did so well in fiscal 2004, it would be more difficult to post similar growth numbers, even if the company and its vast 47,000-strong partner channel executes well. The IT recovery is not that strong, and Microsoft faces plenty of threats in the many businesses it operates in. Connors said that, according to preliminary planning, Microsoft expected that revenue for fiscal 2005 would be in the range of $37.8 to $38.2 billion, with operating income in the range of $15.9 to $16.3 billion, and with earnings between $1.16 and $1.18 per share. Those are pretty precise numbers, so Microsoft must have a decent model of what it thinks customers will do.